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Can You Afford to Buy?

When you decide to buy a house, one of the hardest things to figure out is how much you can afford. The important thing is only to spend as much as you can comfortably afford.

What Do You Need To Know about Home Loans?

Most people bxorrow money to buy a home. If you take out a home loan, then you will have a monthly mortgage payment. This payment has several components. These parts of a mortgage payment are called PITI – principal, interest, tax and insurance.

  • Principal. The principal is the loan amount remaining unpaid.

  • Interest. The interest is the amount charged for borrowing money.

  • Real estate taxes. The real estate taxes are collected each month by the lender until the annual property tax bill comes due, and then the lender pays the tax bill.

  • Homeowner’s insurance and mortgage insurance. Lenders often require homeowner’s insurance and mortgage insurance as part of your payment. Homeowner’s insurance provides protection if something major happens to your house such as a fire, and the mortgage insurance protects your lender in case you don’t make your payments.

What Are Other Costs of Home Ownership?

Too often people consider only the monthly mortgage payment when deciding if they can afford to buy a home. Other costs are also very important such as loan costs, new housing expenses, and current living expenses. When you borrow money, a lender may charge fees such as an application fee. Another initial cost can be points.

Points are a one-time charge by the lender to increase the loan yield. A point is one percent of the mortgage loan amount. These are some possible closing costs. Closing costs are expenses (above the property price) paid by the buyer and the seller.

You can’t borrow all the money you need to buy a house. You will need some cash for the closing costs and the down payment. A down payment is a percentage of the home’s purchase price.

The percentage depends on the type of loan you get. Lenders usually require 20 percent down payment for a conventional mortgage. Some lenders will finance for as low as 10 percent down payment, but require the buyer to purchase mortgage insurance. FHA (Federal Housing Authority) and VA (Veterans Administration) financing requires even a smaller percentage down payment.

What are the additional costs you will have with home ownership? Use
Table 1
to list your current housing expenses and to estimate your future housing expenses. For example, what is your utility bill now and will it increase if you buy a new home?

Consider changes in the cost of your insurance, taxes, commute, tools, and fees such as condo fees.

You may want a "reserve fund" to cover initial new home expenses such as decorating, window coverings, furniture, lawn care equipment, and unanticipated repairs. Try not to do any major remodeling during the first year. If you stretch yourself too far and you can’t pay your monthly mortgage payments, you may lose your home.

Don’t forget to keep in mind your non-housing expenses. Non-housing expenses include food, clothing, entertainment, education, car expenses, medical expenses, childcare, savings, etc. These expenses are important to consider as you look at the mortgage payment figures. Can you comfortably afford the monthly mortgage payment if one of your other expenses (such as medical or childcare) increases?

How Much Money Can You Borrow?

The lender sets a limit on how much you can borrow. Lenders want to know how much of your gross income (your total income before taxes or any deductions) will go towards your mortgage payment. You must qualify to get a mortgage loan. You may want to pre-qualify for a loan so that you can shop for homes in your price range.

To qualify you for a loan, a lender will look at two major factors: your earnings and your existing debt. To decide if you make enough money for a mortgage payment, most lenders use the housing-expense ratio. Typically lenders will allow you to spend up to 28% of your gross income for a mortgage payment. For example, a family earning $50,000 gross annual income earns $4,167 per month gross income ($50,000 divided by 12 = $4,167). This family would qualify for a loan with a $1,167 monthly mortgage payment ($4,167 multiplied by .28). However, keep in mind this ratio uses gross income not take-home income. You must decide if you can comfortably afford this high of a monthly payment plus your other expenses.

Lenders also use the debt-to-income ratio. This method calculates how much of your gross monthly income is used to pay debt. Payments for the mortgage, car loans, credit card debt, student loan payments and other debt are all considered. Lenders often use a 36% debt-to-income ratio. However, taking on such a large payment obligation isn’t wise unless you feel confident you can live on what remains of your income. See Table 2 to calculate your debt-to-income ratio.

Lenders consider other factors too. A poor credit history, unstable income source, or inadequate cash reserves can disqualify you as a borrower. The lender also must approve the house you want to purchase. Usually this approval requires an appraisal of the property.

What Are Your Options?

Don’t be discouraged if at first it seems you can’t qualify for the loan you would like. There are many programs to help first-time buyers. These programs usually offer loans at low interest rates or with a low down payment. Be sure to check on the availability of these first-time buyer loans and also FHA (Federal Housing Administration) and VA (Veterans Administration) loans. You may want to reevaluate the home price you thought you wanted. Perhaps you could qualify for a less expensive home.

It may be that it’s important to pay down your current debt or save some cash before you buy a home. Set yourself a goal to save or reduce debt by a certain date. When you’ve met your goal, apply for a loan again.

By carefully considering all the costs of home ownership, you can choose a home that you can comfortably afford.

Written by Susan Taylor, Consumer and Family Economics Educator, University of Illinois Extension, August 2000.